global risk book

8/4/2019 Global Risk Book

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GLOBAL

RISKNew Perspectivesand Opportunities

Globalization TrendLab 2011


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Globalization TrendLab 2011

Global RiskNew Perspectives and Opportunities


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Based on a conference organized bythe Joseph H. Lauder Institute of Management & International Studies

andthe Penn Lauder Center for International Business Education and Research

at the University of Pennsylvania,sponsored by Santander Universities,

and distributed worldwide through the Knowledge@Wharton network.

2011 The Trustees of the University of Pennsylvania. All rights reserved.


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Global Risk: New Perspectives and Opportunities |

The global financial and economic crisis has heightened everyones awareness of systemic risk.Confidence in the ability of decision-makers, policymakers and institutions to handle such risks hasbeen shattered. Psychology, a culture of destructive self-interest, and social processes have also been

invoked as part of a complex set of conditions that led to the debacle. In turn, the crisis has acceleratedsome prevailing demographic, economic, and social trends, including population aging, political tensions,geopolitical instability and environmental degradation, as the focus of attention has unavoidably shiftedtowards short-term, immediate concerns. The crisis has placed the issue of systemic risk at the top of theglobal agenda, forcing analysts and policymakers to make a stark distinction between what is importantand what is actually urgent.

In this white paper we provide an overview of the causes, consequences, and potential solutions to theproblem of risk, focusing on economic and financial aspects, while also paying attention to political,social and environmental risks associated with the crisis and its aftermath. The analysis represents theoutcome of a collective, multi-disciplinary effort at understanding risk by a group of more than 30 scholars

and policymakers from around the world who gathered in Philadelphia for a two-day conference.

The analysis begins with the conventional explanations of the crisis, further adding political considerationsinstitutional constraints, psychology, and social processes. This prepares the stage for the assessment of theeffectiveness of policy interventions during the crisis which, while averting a massive meltdown, generateda number of additional problems, both short-term and long-term. Failures in global governance and inunderstanding complex ripple effects are also explored. Risks building up in emerging economiesfromfinancial to political and demographicare presented as a stark reminder that global instability ispunctuated by a growing number of troubled hot spots.

The conference participants identified four action items. First, global governance needs to be enhanced, a

task that is not easy as a changing of the guard takes place due to the ascendancy of the emerging economieSecond, regulation must both set parameters for self-regulation and establish a set of cushions, bells andwhistles to ameliorate the possibility of further systemic crises. Third, policymakers and scholars ought toadopt a more humble attitude in terms of the extent to which they are able to understand and overcomethe complexities posed by crises. And fourth, as people adopt shorter time horizons due to incentives,demographics, politics, and cognitive biases, it is important to remain on the alert for the weaknessesand faults in the global economic, political, and social architecture.

Executive Summary


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2 | Globalization TrendLab 2011


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Introduction

Crises represent opportunities for self-reflection. Systemiccrises invite us to revisit our most ingrainedassumptions, habits, and reflexive reactions to events. The recent economic and financial crisis is assystemic as a crisis can be. Perhaps its most devastating effect is that it has shaken our belief in the

efficacy of both markets and government policy. It also represents a stark reminder of the importance oftrust and confidence as the key foundations of all economic and social life. Human frailties and self-destructive behavior have also played a role, as have other psychological and social processes such ascognitive biases, hubris, and social contagion. Many observers have identified the culture of self-interestand indulgence as a contributor to the crisis. Others have highlighted more macro issues such as growingglobal financial imbalances, the lack of effective governance institutions, and the wave of indiscriminatederegulation that preceded the crisis. This bewildering array of contributing factors begs for a trulymultidisciplinary approach to the analysis of the various kinds of risks that have the potentialalone orin combinationto bring about a crisis such as the one the world has just experienced.

Systemic crises affecting a large number of sectors of economic and social activity across many countries

exhibit another important feature. They throw prevailing trends into new light. Developments such aspopulation aging, the rise of emerging economies, geopolitical instability or the race for natural resourcesare not new phenomena, but the crisis has exposed unprecedented and potentially systemic interconnectionamong them. More fundamentally, there is a growing recognition that economic, cultural, political andsocial dynamics are part of an intricate web of cause-effect relationships that needs to be thoroughlyunderstood in order to arrive at a set of corrective courses of action and a catalogue of potential futurethreats. The crisis has put the analysis and management of risks at the top of the global agenda, and forcedall of us to make the distinction between what is important and what is actually urgent when it comes toavoiding similar situations in the future.

Thus, this crisis continues to pose systemic risks not only because it has spread across markets and

countries, but also because it brings to the fore complex interactions among economic, financial, political,demographic, psychological, sociological, and environmental factors. While in this white paper we begin byaddressing economic and financial aspects, we incorporate other types of risks into the analysis insofar asthey help define the global context in which the crisis unfolded. It is precisely at the intersection of differenttypes of systemic risks that a multi-disciplinary approach helps overcome the shortcomings of pastapproaches, for several reasons. First, we need to approach human behaviorindividually and in groupsand organizationsfrom a variety of perspectives and making different assumptions as to the nature andimpact of preferences, cognitive biases and culture. Second, we need to cast a wide net over the spectrumof potential systemic interactions drawing on the different disciplines, especially because truly systemiccrises are relatively rare events. And third, we need to develop mechanisms for inter-disciplinary learningand sharing.

The economic and financial crisis has made us keenly aware of the potentially devastating consequencesof systemic disruptions. The catalogue of threats to the stability and functioning of human societies hasunfortunately increased as a result of globalization and of the growth in scale and complexity of humanundertakings. The activities of corporations, governments, and markets are felt at the local level throughouthe world in ways that reflect the overall pattern of systemic interaction. In the introduction to the


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conference, co-organizer Witold Henisz, Deloitte & Touche AssociateProfessor of Management at the Wharton School, noted that in order togain insight into the crisis, we need to analyze the behavior of individualactors driven by economic and psychological incentives who make decisionsunder conditions of enormous uncertainty. These actors are organized inteams or groups and compete for resources and returns against peers in

other units in the same organization and in peer organizations. Thiscompetition is coordinated by the management of each organizationostensibly to maximize organizational profits. This management is,however, itself operating under uncertainty and driven by economic andpsychological incentives, so much so that coordination is imperfect.Further coordination occurs in the public sector to avoid abuses of marketpower but once again that coordination is imperfect due to the limits onhuman cognition and, at times, the short-term personal incentives andideologies of politicians and regulators. We thus require insight frompsychology, economics, sociology and political science along with guidanceas to what is practically feasible from policymakers and managers.

It is in this multidisciplinary spirit that this report on the first Globalization TrendLab seeks to identify therisks whose materialization led to the crisis, take stock of the lessons learned by academics and policymakersas observers and action-oriented participants, and anticipate the main future threats. We are interested inlaying the foundations for a more comprehensive view of global risks spanning the social sciences, and inoffering fresh perspectives on global risk prevention and management, using the recent crisis as a focusingevent. Our multi-disciplinary approach calls for the application of diverse methodologies and knowledgeto the practical problems facing the world. Our goal is to encourage other scholars, policymakers andobservers in general to take our analysis as the starting point of a continuing debate about global risks andcrises, building on a broader set of assumptions about human behavior and a recognition of the relevanceof politics, institutions, and social processes to the understanding of stability and crises, and to formulating

the remedies to address them.

Witold Henisz


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How We Got HereConventional Wisdom

T

he Financial Crisis Inquiry Commission,charged by the U.S. Congress to investigate

and lay out the causes behind the crisis,identified broad failures in financial regulation andcorporate governance, as well as high levels of debtand risk-taking in the household sector and onWall Street, as the key factors behind the financialimplosion. The Commission also pointed to poorpreparation by policymakers for such an event;lack of accountability; and even breaches of ethics.While the Commissions report was comprehensive,dissenters argued that it was in fact too expansive.In other words, by indicting everyone, the report

had, essentially, indicted no one at all.

Some commissioners wrote notes of dissentclaiming that the causes of the crisis were indeednumerous but not as many as the Commission hadconcluded. They called out certain factors as beingmore important than others, and noted that otherfactors mentioned in the report were of norelevance to the crisis. One commissioner pointedthe finger solely at the housing bubble, claimingthat government mandates for affordable housing

were to blame for the rise of low-quality mortgagesand the consequences that followed.

Such disagreement is not surprising, giventhe complexity of the issues involved andthe fact that the crisis was global in nature.Panelists at the conference generally agreedthat multiple factors were at play; however,like the commissioners, they too haddifferent opinions about which ones weremore important or consequential. Many

would like to believe that the crisis can beattributed to bad policies, regulation,practices, models or people. Such policyfailures, regulatory gaps, operationalweaknesses, formulas, or behaviors arerelatively easy to correct. Others point to aneed for deeper institutional change to

address the rise of new financial instruments in anincreasingly integrated and interdependent globaleconomy.

Stijn Claessens, assistant director of the researchdepartment at the International Monetary Fund,offered an economic and historical viewpoint,noting many similarities between what happenedin the current crisis and what was observed inpast downturns. He pointed to asset price bubblesthis time occurring in housing; a credit boom,this time in the household sector; a decline inlending quality, as often towards the end of theboom; and a lag in regulatory supervision, where

derivatives and other instruments were increasingvery fast and the regulators themselves were notwell-equipped or incentivized to oversee andstop excesses. While weve seen these phenomenbefore, Claessens said, we didnt act on them.

Nonetheless, Claessens said there were some newfactors that led to this particular crisis thatexplain, albeit not justify, the lack of concreteactions on the part of markets and policy makersThe financial instruments involved were probab

more opaque this time around, making it hard tovalue and evaluate them, he noted.

Bruce Carruthers, Harold James, Stijn Claessens and Ann Harrison


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The level of financial interconnectedness bothdomestic and global was high as well, with manynew players coming in (such as smaller Europeancountries) that were not necessarily well equippedto deal with such integration.

Barry Eichengreen, professor of economics andpolitical science at University of California,Berkeley, agreed, saying that the crisis went globalbecause of the extent of real and financialintegration; in an integrated world economyits not surprising that problems in one majorconstituent part the U.S. would haveinternational ramifications.

Another key aspect of the crisis had to do with theconcentration of leverage. Since the indebtedness

was concentrated in the household sector this timein many countries, it was both difficult to detectand hard to manage, said Claessens. Indeed, thehousehold sectors degree of involvement in thiscrisis was unique, which greatly complicatedrestructuring, he noted.

Some people believe global account imbalanceswere a causal factor, noted Ann Harrison, professorat University of California, Berkeley, and directorof development policy in the Development

Research Group at the World Bank, particularlythe rise of demand for assets and supply of lots ofliquidity to emerging markets and other marketsand they think of the U.S. and other countries as

responding by providing more supplies ofperceived safe assets except they werent so safe.These global imbalances are continuing. Everysingle G-20 leader in March 2011 asked, how canwe address these imbalances? How can we putmonitoring systems in place?

Global imbalances certainly played a role, saidHarold James, professor of international affairs andhistory at Princeton University. There were largesurpluses accumulating in a number of emergingmarkets in Asia and in other countries. While itspopular to think of it as simply a Chineseproblem, its not its much larger than that. Thedeficits built up were not just a U.S. problem similar things happened in the U.K., Ireland, Spain,etc. One way of thinking about it is the difficulty of

sustaining these imbalances.

Claessens did not agree that the imbalances were aroot cause. U.S. traded safe assets but so did othercountries in the past. The scale of its doing so waslarger but it wasnt any different than what washappening before. And some countries thatactually had current account surpluses also had afinancial crisis. So it was an element of the crisisbut wasnt necessarily the imbalances themselvesthat caused the crisis. The U.S. was like an

emerging market, channeling resources fromabroad inefficiently, he said.

Like Claessens, Gian Maria Milesi-Ferretti,assistant director in the research department atthe International Monetary Fund, downplayedthe idea of global imbalances as a root cause ofthe crisis. He pointed to several key factors instead:Spectacular growth in cross-border holdings offinancial assets in the advanced economies, alongwith an increase in complexity of financial

instruments and in how exposures went fromcountry a to b; widening of current accountimbalances across the globe and a series offinancial excesses; and big changes in emergingmarkets [some positive] but also in their exposure with more reliance on equity capital flows andless on debt.

In an integrated world economy

its not surprising that problems

in one major constituentpart the U.S. would have

international ramifications.

Barry Eichengreen


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How did the crisis spread so quickly? Claessensnoted that the channels and speed were surprisingbut not particularly unusual. There was directexposure to the U.S. for instance, the Germanbanks took a hit, while others had a wake-up call,similar to Asia and other markets. Spillover

occurred through the asset market, with liquidityshortages and fire sales triggering second-roundeffects. Solvency concerns spread when oneinstitution fell, others were seen as likely to do thesame. And there were perverse feedback loopsbetween the real and financial sectors. As the creditcrunch hit the real sector, it affected the financialsector in the form of worse asset quality.

James offered a similar perspective, and discreditedthe oft-cited notion that the crisis occurred mainly

due to the housing collapse. While laypeople tendto call it a subprime crisis, the subprime issueprobably was not enough by itself to trigger it,

he said. James outlined various themes that hefelt were contributing factors: the character andchange in development of financial institutions,the growth of financialization, the growth ofcomplexity, and the poor incentives within thatsystem, including the remuneration of bankers.Inappropriate monetary policy was yet another

factor, he said: By many criteria, monetary policywas too loose in the 2000s. It let off a big surge ofcredit expansion post 2004.

Eichengreen called upon conference attendees toengage in some introspection, asking what it wasabout the nature of academe that prevented most

scholars from foreseeing what would happen. Idont think anyone anticipated how quickly andviolently the crisis would go global, he said.Through much of 2008 up until [the collapse ofLehman Brothers and to some extent afterwards,

people were seeing the crisis as not only Americanborn and bred but concentrated in the U.S., whichwas clearly wrong. In terms of a number ofmeasures like trade and industrial production,the crisis had already become more severe outsidethe United States than here. When you look atthe crisis globally, it was worse starting in 2007than the Great Depression starting in 1929.

However, he again brought up the factor ofsurprise: The extent and ferocity of the contagio

was surprising to virtually everyone. Put yourselfback in the summer/fall of 2008. Id submiteveryone here was surprised by its virulence.

Eichengreen also pointed to the collapse of tradeas a theme needing further exploration. Tradecollapsed even more dramatically than output,more dramatically than in the Great Depressionduring the 1930s, he said. It wasnt protectionisminstitutions were stronger this time. Other policiewere available to stem the decline in demand it

was not necessary to bottle it up at home to thesame extent as in 1929. The trade collapse couldhave been caused by interruptions in the availabiliof trade credit, but the evidence is not there. TheWorld Bank and others unilaterally stepped inquickly to provide the credit. It wasnt simplyproduction fragmentation issues that nowadays

By many criteria, monetary

policy was too loose in the

2000s. It let off a big surge of

credit expansion post 2004. Harold James

Barry Eichengreen, Suman Bery, and Karl Sauvant


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components of prominent products cross moreborders. That makes for a higher level of trade, soit cant explain the larger percentage decline.Eichengreen said the probable cause was that intimes of high uncertainty, demand for big ticketitems [goes] down. People wanted job assurance

that they were still going to be employed nextyear before buying expensive items like cars.

Another point to consider was why the bankingsector of some countries was affected more thanothers, said Eichengreen. Some succumbed tosubprime mania, either buying toxic deals fromU.S. or engaging in an analogous stuff at home,he noted. Some banks had serious corporategovernance problems in their ownership structureand political environment Spanish cajas,

Germanys Landesbanken, virtually every Irishbank. They were forced to severely contract theirbalance sheets and saw their losses socialized.

Emilio Ontiveros, chairman of AnalistasFinancieros Internacionales and a professor atUniversidad Autnoma de Madrid, noted thatthough the financial crisis spread to Europe after ithad already struck the U.S. economy, it was likelythat its economic and political cost as well as theexpense involved in resolving it would be higher

in the Euro zone than in the U.S. Europeaneconomies are marked by a low rate of GDPgrowth, a very high rate of unemployment and alsoa very high rate of business mortality, Ontiverosnoted. As such, any form of credit rationing has agreater impact on the Euro zone than in economiessuch as the U.K. or the U.S., and this is especiallyevident in the case of Spain.

Ontiveros pointed out that in Europe the bankingsystem, far from being part of the solution to the

crisis, has been a major problem. In Germany, forinstance, banks are among the biggest holders ofEuro zone sovereign debt. However, as the debtcrisis has increased in severity, it has taken apolitical turn and has begun to challenge theeconomic and political integration of Europe.We certainly had Bernanke and other officials

saying, Yes, we have a problem in subprime, butits a very small portion of the fixed incomemarket; it will be confined to those who are heavilyengaged in subprime they did not realize howbroadly those weak assets had been distributed,

said Wharton finance professor Richard Herring.I think it was quite surprising to see that the firstfatality among financial institutions was a smallGerman cooperative rather than a savings & loansin California or another overheated market like LasVegas, or to see Northern Rock fall before any ofthe U.S. banks. So I think theres something aboutnot fully understanding the contagion, simplybecause the instruments had become so complexthat even the people selling them didnt fullyunderstand the risks.

Bradford DeLong, a professor of economics atthe University of California at Berkeley and a U.S.Treasury Deputy Assistant Secretary during theClinton administration, said he was surprised bythe realization that banks and financial institutionsdid not fully comprehend their own vulnerabilityto risk. Three and a half years ago, if asked, Iwould have told you that our banks, highlyleveraged though they might be, had control overtheir risks, and were, by and large, properly

regulated, he said. With all the inspections, withthe industrys experience at quantitative analysis,with all our knowledge of economic history, withsophisticated bosses who understood theimportance of walking the trading floorIthought our commercial and investment bankswere professionals in risk management. But our

Emilio Ontiveros and Bradford DeLong


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highly leveraged banks and shadow banks did nothave control over their risks. Indeed, if you readthe documents from the Securities and ExchangeCommissions case against Citigroup for its 2007earnings call, Citigroup did not know what itssub-prime exposure was, and it seemed to have a

difficult time finding out, even after it become apriority of top management.

There are multiple ways of making financialplayers more aware of the risks they take onthemselvesand eventually shift to the overallsystem. Conference participants emphasized the

importance of incentives, disclosure requirements,and other policies that help decision makersovercome cognitive biases and herding behavior.

Political EconomyNo matter what theories say could cause or averta financial crisis, actual public policy is shapedby real-world politics. Regulating complex newfinancial instruments, leverage or systemicinterdependence requires political will to respondwith a particular policy or regulation which maynot be politically feasible, whereas the politicallypractical solutions may not be ideal from a purelytechnical point of view. Politics is shaped by the

interests of various incumbent organizations andnations as well as by history and ideology. Thepolitical economy of the crisis is thus as or evenmore complex than the crisis itself.

Jeffry Frieden, professor of government at HarvardUniversity, used the issue of currencies to illustrate

the relevance of political economy. The exchangerate is crucial to the causes and consequences of acrisis, whether its the exchange rate relationshipsbetween surplus and deficit countries, or the roleof the U.S. dollar as reserve currency or the Eurozone and its trials and tribulations. Frieden

sought to debunk some widely held illusions abouexchange rates. Exchange rate fluctuations, he saidare not just an unpredictable random walk;regardless of the undesirability of changing policito affect rates, governments have little choice butto try due to the pressures they face from manybroad interest groups.

Frieden also explained that the availability ofhedging opportunities does not make politicalpressure irrelevant; contrary to popular belief,

you cant always insure against massivefluctuations and volatility in foreign exchanges;in many currencies its hard to hedge.

A third area that comes under political influence ismacroeconomic policy coordination, said FriedenThe traditional argument is that theres no

justification for it that all the externalities areinternalized. But from a broader political economperspective, currency volatility and currency levecan impose costs on others. We know from the

past three years experience that different countrieexchange rate policies can create substantial politicdifficulties for their trading and financial partner first through the transmission of crisis effects ansecond via their impact on non-monetary policiesStephen Haggard, a professor at the University ofCalifornia at San Diego, noted that there was a

The exchange rate is crucial to the causes and consequences of a

crisis, whether its the exchange rate relationships between surplus

and deficit countries, or the role of the U.S. dollar as reserve currency

or the Euro zone and its trials and tribulations. Jeffrey Friede


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pronounced regional nature to thefinancial crisis: Europe and theEuropean periphery was hit muchharder than East Asia and LatinAmerica, which had experiencedfinancial crises in the past. He

argued that efforts to undertakereforms in the wake of those crisesmade countries less vulnerable toshocks this time around.

Corporate governance was at leasta contributing factor to past crisesin Asia, as family-controlled groupsexploited relations with thegovernment and banking sector and expropriatedvalue from shareholders, he stated. In 2008,

however, Asia bounced back quickly. The 1997-98financial crisis was followed by fairly substantialreforms, he noted. In Indonesia reforms werearguably most sweeping, because you had a regimechange. But even in Korea and the Philippines,what I call market-oriented populists used thecrisis to push reforms in business-governmentrelations.

In Latin America, Haggard highlighted the recentevolution towards left-leaning governments but

noted that many of these parties had movedtowards the center when it came to fiscal policy.Political leaders in Chile and Brazil believe therewere electoral advantages from fiscal responsibilitylaws, strengthening the central bank, and tacklingold bugaboos such as an aversion to foreign directinvestment. The result, Haggard added, is thatcompared to the steep increase in governmentdebt on the European periphery, the debt to GDPratio in Latin America is only about 40%.

Summing up, Haggard felt that a significant factorin both these non-crisis regions was a dramaticexpansion of social policy commitments followingthe transition to democratic rule that began in the1980s. I always like to remind American audiencesthat Korea and Taiwanalthough highly-competitive, export-oriented economiesboth

have national health insurance.While he did not intend to dismissadverse trends in Bolivia, Venezuela,Ecuador and Nicaragua, Haggardfelt that they proved his point.Even in those cases, you could

argue that the problem was preciselythat they had weak democraticinstitutions, not that they weredemocratic. Their party systemswere fragmented and didnt grantadequate representation topolitically-significant groups .

In this vein, some have suggestedthat the pacification of the middle class was anunderlying root cause of the crisis, noted

Harrison, and that the enormous increase ininequality which also built up right before the 1929crisis was such a problem that one response was toplacate the middle class through low-cost housingloans. She asked what the panelists thought of thistheory championed by Raghuram Rajan of theUniversity of Chicago and Branko Milanovic atthe World Bank.

Claessens proposed another perspective, pointingout that economists like Daron Acemoglu argued

there was financial engineering going on where therich were starting to steal from the middle class,and the mechanism to do that was to offer themhouses that they couldnt really pay for, with cheapfinancing. So there are a lot of things happeninghere at the same time. Theres a link, but Im notsure there is a causality.

Eichengreen pointed out that political economyand ideology played a role in the crisis politicaleconomy in the sense that the regulators were

captured by the regulated, and the ideologymanifesting itself in the extent to which theregulators were consciously starved of resources.He added that the case for capital controls of onesort or another has gained ground since the crisis,but unfortunately, he noted, the world has notmade much progress in addressing inadequate

Ann Harrison


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Global Risk: New Perspectives and Opportunities | 1

governance. Several participants commented thatnational sovereignty and politics often preventglobal governance solutions from taking hold.

Bruce Carruthers, a sociologist at NorthwesternUniversity, pressed Eichengreen on the issue ofwho is at fault Do you have some generalsuspects to round up, particularly when youwere talking about the role of ideology regulatorsarent watching whats going on, bad things canhappen. Who are the bearers of this ideology?Where did it come from? Was it discredited?

Eichengreen responded by saying that he hadin mind partly the ideology of marketfundamentalism the belief that self-regulation

will get us a long way toward where we want tobe a belief some influential policymakers andinfluential academics encouraged. But also [Imthinking of] the mechanisms of what kinds ofarguments are easier or more difficult to publish,float in seminar rooms, etc.

Frank Dobbin, professor of sociology at HarvardUniversity, discussed political economy issuesthrough the lens of agency theory as the solutionto the conflicts of interest between managers and

shareholders. In the 1980s and 1990s, he explained,U.S. firms changed their basic approaches tostrategy and compensation, governance, andoutside monitoring thanks to agency theory,an idea pushed by investment fund managers toadvocate for shareholder value.Claiming that managers and owners of firms

had an inherent conflict of interest, the theoryprescribed certain measures some designed tomake firms more entrepreneurial and risk taking,and others to constrain CEOs risky behavior. Inpractice, Dobbin said, firms took up all the

prescriptions that would encourage risk taking bunot really the ones designed to check risk throughincentives and monitoring.

Agency theory prescribed a reduction in productdiversification in order to prevent companiesfrom acquiring for the sake of empire building.A single-industry firm, however, faces greater riskin downturns. Debt financing (making companieborrow to expand), another pillar of the theory,was supposed to discourage stupid acquisitions

that happened when CEOs had cash lying aroundand wanted to build bigger empires, said DobbinBut firms with lots of debt can fail.

Some have suggested that the pacification of the middle class

was an underlying root cause of the crisis, and that the enormous

increase in inequality which also built up right before the 1929 crisis

was such a problem that one response was to placate the middle

class through low-cost housing loans. Ann Harriso

Firms took up all the

prescriptions that would

encourage risk taking but not

really the ones designed tocheck risk through incentives

and monitoring.

Frank Dobb


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On the compensation side, agency theory talked upstock options, to reward executives for increasingthe firms value. But in practice firms simplystructured the options in such a way as to rewardrisky short-term gains (with no penalties for

losses). With such incentives, CEOs had everyreason to play roulette, taking extreme risks, saidDobbin. Another idea of agency theorists wasexecutive equity long-term compensation plansto minimize risk-taking by making executivesowners of the firm. By and large, said Dobbin,firms didnt do it.

Agency theory also advocated board independence.Smaller, more independent boards made up ofoutsiders could constrain risk and even fire lousyCEOs, said Dobbin. While companies did reduceboard sizes, they were still chaired by the CEOs.When the CEO is chair, the board doesnt fire theCEO, noted Dobbin.

In every case, said Dobbin, companies cherry-picked changes and applied them selectively inthe name of agency-theory based reform. Suchchanges certainly played a role in scandals likeEnron and WorldCom, but they also contributedto the subprime crisis, Dobbin explained. Thesemanagerial changes were transferred to investment

banks. In 1970 investment banks were partnerships.By 1999 they were all public companies, followingthe shareholder value model.

If investment bank executives didnt stand tomake money on options, said Dobbin, thesecompanies wouldnt have invested billions of

dollars of borrowed money in risky financialinstruments. The question now is whathappens in the rest of the world? If these[shareholder-value] prescriptions appearelsewhere, in bastardized form, it wouldcreate the same set of perverse incentives.

Simeon Djankov, deputy prime minister ofBulgaria, offered a European perspective onthe effects of politics on economic policy.When the crisis started, Djankov explained,there was much happiness in Europe, saying

this is all Americas mistake, this is the end ofAmerican capitalism. It took quite a while forEurope to acknowledge that the problem wasnt

just in the U.S., he said. Even when this happened,people were unwilling to break their routines: The

first response was, OK, we have to do something but its summer, so first we go on vacation.

When everyone returned from vacation, anotherissue came up an election in one of the biggestEU countries. Djankov said that because of suchpolitical cycles, the EU lost about a year and a halfin which something could have been done, simplybecause of unwillingness to act in the midst ofthem. As Europe worked through Greeces crisis,then Irelands, then Portugals, they were caught

time and again in electoral and policy cycles andwere forced to delay actions, he said.

According to Ontiveros, clear asymmetry betweenmonetary union and the lack of coordination of

Gian Maria Milesi-Ferretti, Simeon Djankov, Christine Wallich

When the crisis started, there

was much happiness in Europe,

saying this is all America'smistake, this is the end of

American capitalism.

Simeon Djankov


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fiscal policy among European countries isprobably the most important reason to explain thegravity of the sovereign debt crisis in Europe,Ontiveros noted. In his view, the most importantpriority is to reduce the risk premium in the debtmarket. While this is undoubtedly a difficult task,

the removal of the threats to public debt marketsin the Euro area is one of the necessary conditionsto finally overcome the global crisis, he concluded.

Such policy responses are, however, inherentlydifficult. DeLong drew from the Americanexperience and noted that no regulator wanted toget in the way of lenders willing to borrow, creditorswilling to lend and banks willing to issue. If youdid, Congress would have demanded Greenspanshead with bipartisan consensus. It was perceived

to be better to wait and clean up the mess later.

Institutional AnalysisBeyond economics and politics, one must alsoincorporate institutions into the analysis of globalmarkets. They are also important to the analysis ofthe causes and the effects of crises. In fact, theglobal economic and financial crisis can beconceptualized as an instance of massiveinstitutional failure. Institutions include formalrules and informal norms, cultural understandings,

and other types of structures that enable theinteraction of sellers and buyers in the market,placing limits on what they can and cannot do,and providing a framework for policy intervention.Markets cannot work without a broader institutionalskeleton that is itself dynamic and subject to influenceby the various actors involved, especially governments,international agencies, and large businesses.

Glenn Morgan, professor of internationalmanagement at Cardiff Business School, Cardiff

University in the U.K., chose the case of the over-the-counter (OTC) derivatives market as anillustration of the importance of institutions.His reason for adopting that approach, he noted,was that this reveals to us a lot about thecomplexity of the relationships between privateactors and public actors. And also, it reveals some

of the complexity about the relationships betweennational regulation and international regulation.

Morgan pointed out that from a standing start inthe early 1980s, OTC derivatives had evolved intoa $595 trillion market by 2007, according to theBank for International Settlements. We see amarket thats established incredibly rapidly, andalso becomes, as Bernanke pointed out, central tothe financial structure in the 2000s into the sub-prime crisis. The nature of OTC contracts is thatthey are bilateral, which makes them opaque and that makes it difficult for outsiders to assesstheir risk. After the Commodities FuturesModernization Act of 2000 was passed, OTCcontracts became legally enforceable but the lawalso made it clear that the market was to remain

unregulated. This enabled this market to expandhugely to take on all sorts of risks. Because it wasall bilateral, there were no clear rules aboutcollateral, margins, et cetera. And so we havethe case of AIG signing massive amounts of OTCcredit default swaps without putting anythingaside to cover the cost of such contracts. Morganthus emphasized the abdication of regulatoryresponsibility in crucial areas such as thederivatives market as a chief cause of the crisis.Transparency was also lacking due to the lack of

accounting standardization and a true market-based clearing mechanism.

As efforts have been made to create centralclearing houses in order to manage these risks,Morgan notes that what were seeing isa sort ostruggle between private actors and public actors.

No regulator wanted to get in

the way of lenders willing to

borrow, creditors willing to lend

and banks willing to issue.

Bradford DeLon


17/42


Here, obviously,its the U.S. thatwas crucial towhats going on.Dodd- Frank,and how those

rules areimplemented, isgoing to becentral to thedegree to whichthere remains asignificant OTCelement with thesort of risks that

are retained in an OTC environment, as opposed tothings coming onto clearing houses. I think that in

terms of the international context, the U.S. isleading in terms of legislation. Will regulationlead to a reduction of risk? Morgan is not certain since the regulations themselves are so new.Compared with what regulators in the G20countries may have expected in the aftermath ofthe crisis, certainly no major reduction in risk hasoccurred, Morgan said.

Also emphasizing the institutional underpinningsof the economy, Northwestern University professor

Bruce Carruthers offered a nuanced analysis ofhow the crisis posed a challenging combinationof uncertainty, complexity and interdependence.He noted Chicago school economist FrankKnights conditions for decision making:

Under certainty, the decision maker knowswhat will happen and can choose the bestalternative.

Under risk, the decision maker doesnt knowwhat will happen, but knows the probabilities

under which outcomes occur. Under uncertainty, decision makers dont

know what will happen and also dont knowwhat the probabilities are.

While certainty and risk are relatively easy to dealwith, true uncertainty poses a problem. Too often,

said Carruthers, people deal with uncertainty bypretending it is risk.

To do so, of course, market participants makeassumptions. Those assumptions often implicitand unstated about what is likely or unlikely to

happen are often made, noted Carruthers, basedon the assumptions of their peers. The danger,obviously, is that if everyone makes the sameassumptions, any violation [of them] blindsideseveryone.

Psychology, Social Processes, andIndividual ResponsesHuman frailties, cognitive assumptions, leadership,and suffering were as important to the unfoldingof the crisis as the large-scale rules, norms and

policy interventions discussed thus far. Too often,accounts of the crisis completely neglect the humanelement. Whats missing, noted Eichengreen, is[acknowledgment of the] pain and suffering at theindividual and household level.

Individuals capacity to process information overtime also plays a key role in how they respond to acrisis. Jack Goldstone, professor of public policy atGeorge Mason University, noted that low-probability or low-frequency events are more

difficult to plan for. Major financial crises are seenabout once every 30 years or so, said Goldstone.Its those kinds of events that give us the mosttrouble when it comes to risk. Japan was notprepared for a tsunami to cause partial meltdownsin half a dozen nuclear reactors, but [the reactors]were actually built on the site of an 1896 tsunami

Bruce Carruthers

The crisis posed a challenging

combination of uncertainty,

complexity andinterdependence.

Bradford DeLong


18/42

that reached 125 feet. The 2011 tsunamireached 124.8 feet nothing that hadnt beenseen before. But the fact that it happened 100

years ago meant essentially it was discountedas a possibility.

Michael Useem, a professor of management atWharton and director of the schools Centerfor Leadership and Change Management,noted the need to learn from past experienceon managing risk. People who deal with riskat the enterprise level whether at acorporation, in government agency or in aregulatory institution tend to think abouthow to minimize risk before a crisis occurs,and they also examine responses to crises afterthey have happened to see what measures are in

place to avert potential catastrophes. A usefulanalogy can be drawn to the armed services allover the world, which conduct what are calledAfter Action Reviews. Useem said companies suchas Exxon Mobil have been through a wringer,which has forced them to rethink what measuresthey have in place to deal with risk. We have tolook to the future by first looking to the past.

Social norms and shared cultural understandingsthat played a role in the crisis, argued Carruthers,

triggered social processes that caused theseoutcomes. One hallmark of the crisis concernedhow many people were surprised by events, henoted. Who knew AIG had become so central tocredit default swaps? Who knew that the fall ofLehman Brothers would become so consequential?Who knew that so much AAA-rated structured debtwas so overrated? Even among those who did knowbetter, many felt compelled to act as if they didnt.The geographical concentration of many of theplayers Wall Street, the City in London,

Greenwich, Conn., Tokyo exacerbated thesituation, said Carruthers. Physical proximitymeans that financial elites move in overlappingsocial circles, he said. Carruthers pointed to threesocial-process features that influenced how peopleacted in these small worlds: homophily, peer-based benchmarking, and status.

Homophily, said Carruthers, occurs when people

seek out and surround themselves with otherswho are like them. While natural, people riskbecoming isolated in a social and intellectualecho chamber, where those around us confirmour expectations and share our assumptions,Carruthers explained. This can make it difficultto obtain truly new information and ask trulychallenging questions.

Homophily is reinforced by peer-basedbenchmarking and imitative search: If our peers

are doing something, we are likely to start doing itoo. When deciding what to do, we look at whatthe competition is doing. Best practices, oftenpromoted by consultants, serve as anotherhomogenizing factor. This and other types ofinformational cascades can beget herdingbehavior, said Carruthers.

Status is a third factor that reinforces this behavioSince its hard for low-status people to challengehigh-status people they risk being fired or

ridiculed, it can accentuate the echo chambereffect, noted Carruthers. Through the 1990s and2000s, the U.S. financial sector enjoyed risingwages and the ability to import the cream of U.S.higher education. So even if the emperor knows hhas no clothes, its hard to do anything about itwhen all the other emperors are nude as well.


Frank Dobbin, Jeffry Frieden, Jack Goldstone,Karl Sauvant and Ed Mansfield


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Princeton history professor James had a slightlydifferent take on Carruthers idea: Bruces story that were coming together in global villages andpeople are imitating each other is in a sensewrong because people cant communicateadequately and dont know what other people are

doing. A famous example of this is Citigroup ithad more than 60 different computer operatingsystems that couldnt talk to each other, so nobodywas in a position to really put it all together and tosee where precisely risk lay. So its a global village,but one that is talking at odds, not talkingcoherently.

Either way, an aggravating phenomenon, saidCarruthers, is the tendency of people to usecategories, cognitive devices and schemata to

simplify complex data: Lots of uncertainties getabsorbed. An example of this related to the crisis,he said, is the credit rating: Decision makers focusonly on the overall rating precisely so they canignore all the underlying information.

Such summary information is so accepted thatratings downgrades can have huge implications.En masse, pension funds and insurancecompanies have to unload assets that have fallenbelow investment grade, said Carruthers. And

those schemata are a bunch of largely unexaminedassumptions about the way the world works, aboutwhats relevant and what is irrelevant. And itcan synchronize activity in unexpected andunhelpful ways.

When everyone uses the same assumptions andrisk models, it accentuates herding behavior.With high levels of interdependence, a strategythat might work well for one person may becomedetrimental if everyone uses it, much like rushingfor the exits in a crowded movie theater,

explained Carruthers.

Interdependence, Carruthers added, is rootedin networks. How networks are structured affectsthe way information and innovations are spread.Typically, organizations are embedded in multiplenetworks at once. Because of their implications foroverall stability, regulators have become interestedin the macro structure of networks.

While the rules of the economic game laws,

regulations and other systems can enhancepredictability, during a crisis, the rules can besuspended suddenly and in unexpected ways, saidCarruthers. This is particularly true in capitalistdemocracies where the polity and economy closelyinteract and where the state of the economy is apolitical issue.

Carruthers explained that this is where the issueof too big or too connected to fail comes in generally, market economies are supposed to

self-correct, but often it is politically impossiblefor governments to sit by when institutionscollapse and take down large swaths of householdswith them. n


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Policy Interventions

W

ere there any areas in which governmentsor other institutions did things right

during or after the crisis? Several expertssaid yes. People compare the great recession withthe Depression. One reason we didnt have adepression was that people learned lessons fromthe Great Depression, said Princetons James.One, learned in some countries more than others,was the Keynesian lesson on the need for fiscalstimulus. Big countries did this particularly well.We also learned monetary policy lessons itsclear the Fed has deeply absorbed this.

The third lesson was more problematic, notedJames. During the Great Depression the U.S.didnt have megabanks that were too big to fail.But the Europeans did: Their crisis was triggered inMay 1931 by the failure of Austrias Creditanstalt.It was clearly too big to fail. Suddenly a fiscalposition that was good before became terrible andcaused a currency crisis. These too-big-to-fail bankfailures take years to resolve; they cant be donewith simple policy measures. And indeed thelegacy of those interventions lasted multiple

decades. Its much harder to do microeconomicadjustments.

In many ways, agreed experts, things could havebeen worse. While household and governmentand some financial institutions balance sheets are

still shaky, if you look at the high-grade corporatesector in the U.S., Europe, Japan its in prettygood shape lean and mean, said NourielRoubini, co-founder and chairman of the economigeostrategic consultancy Roubini GlobalEconomics and professor of economics at NewYork Universitys Stern School of Business. Theycut labor costs brutally. It meant massive job lossebut now they are running efficiently and profits alooking up. If they get more confidence and startspending more, it could lead to recovery.

The dog that didnt bark in the response to thecrisis, differentiating the great recession from theDepression, mainly would be the relative absenceof significant trade protectionism, said Ruggie.Tariff barriers didnt shoot up; U.S. anti-dumping cases didnt skyrocket. There was a lotof noise about Buy American but there was asurprising absence of protectionist response tothe crisis.

Its indeed one of the things that causes peopleto be optimistic, conceded James, that wehavent had a major reversal into protectionism.But economic historians are always ratherCassandra-like on this issue. The really bad bitof protectionism during the Depression wasntat the beginning; it was really a response to thecredit crunch in 1931 and 1932, when countriesthat were faced with tremendous monetarydeflation had to do something to stop it andthe most obvious thing to do was to take trade

measures. If you look at the public stimuluspackages in Europe today, often there are concernthat they shouldnt be used to prop up foreignproducers. Moreover, Harrison noted thatcurrency manipulation became the leading formof protectionism during the crisis.

Lessons Learned

People compare the great

recession with the Depression.

One reason we didnt have a

depression was that people

learned lessons from theGreat Depression.

Harold James


21/42


We have seen someprotectionism on thefinancial side, morethan on the trade side,said Claessens. [Wesee it in] the structuring

of recapitalizationprograms, somelocalization of capitalflows hopefully thesewill be temporary.

Phillip Swagel, nowat the University ofMarylands School of Public Policy, was assistantsecretary for economic policy at the TreasuryDepartment between 2006 and 2009, and hence

squarely in the eye of the storm during the financialcrisis. He provided an insiders account of his viewof the crisis. As the Treasury Department wasforced to respond to a burgeoning crisis thatincluded the failure of Fannie Mae and FreddieMac, the impending collapse of Lehman Brothersand Merrill Lynch as well as default risks at AIG,officials realized that they lacked the legal authorityto do so. Legal constraints were accompanied bypolitical constraints, Swagel said.

With so-called 20-20 hindsight, most of Swagels

comments focused on lessons learned as a result ofthe crisis. Fiscal policy is a tool, he said, addingthat some types of fiscal tools work better thanothers. That government spending is really notvery effective on a large scale, is, I think, one of thelessons weve learned from rapid stimulus. Itsreally hard to spend money quickly and with

effective quality. Hedescribed the lattercourse as the epitomeof burning taxpayerresources.

Speaking about theTroubled Assets ReliefProgram (TARP),under which theFederal governmentacquired assets andequity from troubledfinancial institutions,

Swagel noted that one of the key lessons learnedwas that there are limits to monetary policy. Inaddition, he said, when a crisis exists as a result of

inadequate capital, monetary policy tends toregard it as a liquidity problem.

In some instances, such as AIG, that is indeed thecase the problem is lack of liquidity. In othercases, though, the problem is solvency, not liquidity.In some sense, in not lending to Lehman Brothers,the Fed faced the same sort of decision as theEuropean Central Bank did in lending to thetroubled banks of Ireland and Greece.

DeLong noted that his confidence in the ability

of central banks and governments to intervenesuccessfully in financial crises was misplaced. Ithought the Federal Reserve had the power andwill to stabilize the path of nominal GDP, he said.Economists have long believed that when demandfor currently produced goods and services iscrashing, because households and businesses find

Glenn Morgan, Phillip Swagel and Emilio Ontiveros

That government spending is really not very effective on a large

scale, is, I think, one of the lessons weve learned from rapid stimulus.

Its really hard to spend money quickly and with effective quality.

Phillip Swagel


22/42


themselves short of the safe, liquid vehicles ofappropriate duration in which they want to parktheir wealth, its the business of the government[and] the Central Bank, to fix the situation andgive the private sector the financial assets it wants.The ability of governments and central banks to

stabilize financial markets had been tested inseveral crises, he added, for more than two decades.These included Black Monday in 1987; the Savingsand Loan crisis of the early 1990s;the Mexican peso crisis; the EastAsian crisis; the Russian statebankruptcy; the collapse of LongTerm Capital Management; thedot-com and tech bubble crash ofearly 2000, and many others.

In all of these, the FederalReserve, without breaking a sweat,intervened strategically in financialmarkets to successfully buildfirewalls between the effects offinancial panic, if any, and effectivedemand for goods, services, andlabor, on the other, DeLong pointed out. As aresult, economists began writing papers on thegreat moderation, trusting in the ability ofgovernments and central banks to keep financial

markets stable.

Unfortunately, experience now shows that thegovernments ability to intervene in financialmarkets works only as far as the governmentsstatus as an issuer of safe and liquid assetspersists, DeLong explained. If confidence inthe government cracks, then, all of a sudden, themonetary and banking with fiscal policy optionsgo way, way downSo my belief that the FederalReserve and the government had the power and

the will to stabilize the growth path of nominalGDP was also wrong. I dont think I was wrongbecause the government does not possess thetechnocratic power. I was wrong because thegovernment does not possess the political willand the technocratic clarity of thought tounderstand what strategic interventions in

financial markets are appropriate in the aftermathof a financial crisis.

Finally, DeLong said he thought that economistshad an effective consensus on macro-economicpolicy that the task of the government was to

stabilize nominal demand and to keep nominaldemand growing at an appropriate rate, and to dowhatever was necessary in order to keep the flow

of nominal demand more or lessstable. That belief, too, turned outto be erroneous, he said.

Suman Bery, a member of IndianPrime Minister Manmohan SinghsEconomic Advisory Council, focuseon the lessons India learned about

managing global risk during thefinancial crisis. We learned thatcounter-cyclical policy is possible,and this was new for India, henoted. It has become a much moreintegrated and open economy in thelast decade. We were new at the gam

but because we had experienced leadership, andthe prime minister himself is an economist, durinthe financial crisis they got it right. I was one of thcritics of the buildup of reserves. But the reserves

were very important for calming the domestic, aswell as the international financial markets. Eventhough were not as well managed fiscally as manyof our peers, we took the gamble of actually lettinreserve stock go down, and we werent penalizedby the markets. That was a huge learning.

Is the hierarchy of global risk different for a poorcountry like India? According to Bery, among allthe major emerging markets, India is furthestbehind in the transition of labor from the

countryside to the cities. Global integration hasbeen very important for its growth spurt in the ladecade, he noted. India is coming to the partyvery late, when the rules of the game are in serioudanger of being reshaped. The old upholders ofglobal political open trade, essentially the UnitedStates and to some extent Europe, seem to be

Bradford DeLong


23/42


reconsidering theircommitment to tradeopenness. And yet its goingto be very difficult for Indiato achieve its structuraltransformation without an

open global trading system.

Alejandro Werner, a professorat Madrids IE BusinessSchool and Mexicos deputytreasury secretary duringmuch of the crisis, offeredsuggestions that governmentscould pursue as an economiccrisis unfolds. It was critical, he noted, thatgovernments should recognize that the goal of

sovereign risk management policy is to reducerisk. Governments also need to recognize theimportance of good macro-economic policy,including a strengthening of the governmentsfiscal position, prudent regulation of new financialproducts, and anticipation of major shocks fromabroad, especially those having to do with drasticchanges in prices, including commodities andenergy.

A Failure of Global Governance

John G. Ruggie, a professor at Harvard KennedySchool of Government and affiliated professor inInternational Legal Studies at Harvard Law School,noted that while globalization has transformed theworld profoundly, the global governance systemhas not kept up with the pace of change. Theglobal regulatory system, to the extent that we cansay that one exists, has fallen well short in providinga social pillar for economic globalization, hepointed out. To make matters worse, the pressurefrom economic globalization has undermined

domestic social pillars, as we see in the disintegrationof labor unions in the United States. So thegovernance gap, the misalignment, is made worseover time, rather than better. At the same time,developing countries often do not have theregulatory standards to protect their workers or theenvironment. They compete against one another

to attract foreign investmentand therefore often lowerstandards, he added. Theresult is that suchmisalignment endangersindividuals as well as the

communities in whichcorporations operate.

What are some of the worstcases? he asked. Well, heresa short list of actual cases:Forced relocation ofcommunities to make wayfor a mining project; security

forces, hired to protect oil company pipelines,raping and killing villagers; a company providing

transportation and logistical support togovernment forces that are then used in thecommission of genocidal attacks on oppositiontribal territories; entire apparel factories burningto the ground with hundreds of workers insidebecause the doors are locked to prevent themfrom sneaking out for breaks.

Ruggie has worked for years with business,

government, communities and NGOs to developa blueprint for a soft law instrument that wouldhelp protect human rights, workers rights, andcommunity rights, and also win the support ofcorporations and governments. The lack of suchlegislation has proved expensive, he noted.

Mauro F. Guilln and Alejandro Werner

The global regulatory system,

to the extent that we can saythat one exists, has fallen well

short in providing a social pillar

for economic globalization.

John Ruggie


24/42


A Goldman Sachs studyon 190 projects startedby international oilcompanies indicatedthat the time it took fornew projects to come

on-stream had doubledduring the past decade,causing significant costinflation. The studyshowed that the costescalation was causedby technical andpolitical complexity. Ruggie approached one ofthe oil companies and tried to delve more deeplyinto the causes. What we found is that non-technical risks account for nearly half of all the risk

factors this oil company faced. What they calledstakeholder related risk, that is, pushback fromcommunities, was the single largest category of risk.

Ruggie asked the company to come up with anactual figure for the so-called value erosion. Sothey went back over a two-year period, and theydiscovered that they had lost $6.5 billion. Theycalled it value erosion, from stakeholder-relatedrisk, which they had not known about. Why didthey not know about it? The reason was that the

numbers were never aggregated to a level wheresenior management could see them. Theyremained with the local operating units, and theywere absorbed into operating costs.

Ruggie recommended that companies widen thedue diligence they conduct before setting up theirbusiness, by asking questions such as: Youregoing to build a mine here. How many people isthat going to attract? Is there housing? Is therewater? Are there roads? Is there electricity? And if

not, where is all this going to come from? Whatkind of pressure is that going to put on you, on thelocal government? Is the local government capableof dealing with it? If not, youre going to end upbeing at the receiving end of the demands. Whatcan be done ahead of time? The same kind of duediligence should be carried out periodically

throughout the lifecycle of a project.In a similar vein, EthaKapstein, a professorof political economy aINSEAD and visiting

fellow at the Center foGlobal Development,noted that corporatesocial responsibility(CSR) projectsgenerally consume,at most, some 1% of

turnover at multinational firms. He proposed analternate risk mitigation strategy to CSR projects involving the use of local supply chains to dealwith social concerns. Leveraging your local supp

chain, leveraging your sourcing, requires managerto think strategically about how they relate to thesocieties in which they operate, Kapstein said.It requires them to go beyond a simple costcalculation. The appeal, of course, of globalsourcing, is that your supply chain manager, yourcurrent manager, can go to the internet and sourcthings at the lowest cost, without taking intoaccount the externalities associated with thatdecision. Local sourcing requires that you thinkabout those costs more strategically, and you thin

about what those externalities are.

In support of this argument, Kapstein proposedthe following hypothesis: The greater the impactof a firms sourcing decisions on local economiesthe more constituents the firm will develop insupport of its strategic goals.

Kapstein offered the example of a multinationalfirm in Africa, which decided to stop using a localfirm that was training its workers and outsourced

the task to a global consulting firm based in LondonWhat the multinational did not understand wasthat the local firm was not just educating theworkers to do their jobs well. That local firmdidnt just deliver training. It also delivered a lotof political support for that company. It had greatcontacts with the capital. It knew the players.

Nicole Woolsey Biggart, Ethan Kapstein and John Ruggie


25/42


Such decisions tend to escalate tensions betweenheadquarters and people working on the ground,Kapstein said.

Kapstein contrasted this approach with the oneadopted by a U.S. company involved in gold mining

in Ghana. While he had expected the company tojust go into the area, excavate the gold, and leavethe region worse off than before, he was surprisedto learn the mining firm had built positive linkageswith the local community. In fact, what we foundis that the linkages the firm had created with thelocal economy were incredibly profound through astrategic sourcing decision. Even though the mineitself only employs 1,800 people, it supports 50,000people throughout the Ghanaian economy, so ahuge multiplier effect was created through the

strategic sourcing decisions the firm made.

That is how deploying local supply chains cantranscend the impact of local CSR programs,Kapstein argued. Its nice to build a school or ahospital or to support a soccer team. But throughstrategic sourcing decisions and the use of localsuppliers, you may be able to support 50,000 people.Thats a huge political constituency on your behalf.

Another case in point: Heineken, the Amsterdam-

based beer brewer, which operates 140 breweries inmore than 70 countries. According to Kapstein,Heineken goes to great pains to become a localcompany in the countries where it does business.In Africa, for example, it tends to source localsorghum rather than import barley. It focuses onlocal impact, on local employment, local training.That is a way to build brand loyalty, but its also away strategically to fight off increases in excisetaxes. Why? Because if a multinational firm goes tothe Ministry of Finance and says, We want lower

excise taxes, theyll be thrown out of the room.But if 50,000 farmers come in and say, If you raiseexcise taxes, you hurt our incomes, then thegovernment is at least going to listen. Again, itshow you make strategic use of your politicalconstituency. Not all companies had this kind of

far-reaching attitude, Kapstein said, adding thatmany senior managers had no idea of who theirsuppliers were.

Nicole Biggart, a professor at the University ofCalifornia-Davis Graduate School of Management,

noted many companies are becoming aware oftheir carbon footprint and starting to push theirsupply chains to reduce the environmental impactof sourcing. Theres a sustainability consortiumwith 70 firms that are trying to measure every stepin supply chains, she said. It was instigated byWal-Mart, but Best Buy, Carrefour, Marks andSpencer and a lot of big manufacturers andretailers recognize that its going to be importantto measure carbon because having a large carbonimpact is very risky.

Noting that the conference was about systemicrisk, Biggart pointed out, There is nothing moresystemic than our environment. Water, air, youname it if it is environmental property, we allshare itYou cant separate my water from yourwater. If the ocean gets acidic, it disrupts foodsupplies for ocean-living creatures and it impactsall of us. So the environment is the true systemicconcern. We have very new property rights issuesbut we dont have ways of thinking or talking

about them because our notion of property rightsis rooted in very different understanding. We sharesystemic risk, but we do not govern ourselvessystemically.

Solutions to environmental issues are being found but so far these are often at the level of cityadministrations or regional governments, ratherthan at the national or global level, according toBiggart. San Francisco has zero emission busesbecause its cheaper over the long run. In London,

33 boroughs have planted two million trees. Parishas just launched a 300 car electric car share with50 regional cities. At that level, things get done. Newgovernance forums are being developed. Many ofus are very much concerned with nation states, butnation states are not where its happening. n


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Because of Ineffective Remedies,

Systemic Risks Endure

There is a growing consensus among expertsthat the underlying conditions that producedthe crisis have not been neutralized. We

managed to respond to the immediate threatsof the financial meltdown and to avoid the mostdevastating scenarios, but the longer-term driversof global instability remain active. In fact, the crisishas accelerated long-standing trends that couldbring about volatility and confusion, including: therise of the emerging economies, some of which are

overheating and could suffer from the bursting oftheir own bubbles, sooner than we think, accordingto Yasheng Huang, a professor at the MIT SloanSchool of Management; the changing agecomposition of the population; a potential risein nationalism and/or protectionism; the limitedability of highly-indebted governments in the richcountries to cope with further economic problems;and the enhanced competition for scarce naturalresources and energy. We can conclude that manyof the underlying causes of the crisis have actually

not been addressed which is potentially ominous,said Ann Harrison.

Government interventions, said Claessens,were largely what had been seen before in pastcrises liquidity support, bank recapitalizations with the same mistakes as before. As we takestock today we have to admit we didnt go as faras we wanted to with regard to reform andrestructuring.

The initial vector of contagion, noted Herring,was that after Paribas refused to pay out, thebanks lost confidence in each other. Trade financedepends heavily on that trust. We wasted a whole

year trying to interpret that as a liquidity crisis,and it was evident to the banks themselves that itwas a solvency crisis. All the central banks were

just pouring liquidity into the markets instead of

dealing with the solvency issue.

Entire countries can have destructive discountrates, said Goldstone, if they become focused onshort-term rather than long-term futures. Onereason the East Asian Tigers had done welldevelopmentally is that they were lucky to haveleaders who put a higher value on their countriesas a whole moving up in the global league tablesthan on their personal power and position. Howwe do this for a whole country may be a matter of

leadership or may be a matter of events changingthe discount rate. We keep making the samemistakes because we dont seem to have a leversaying, Heres something that may happen in 30

years. We have a What has posterity ever donefor me attitude.

It would be interesting to see whether theres acategorical difference between democracies andnon-democracies, said Carruthers, particularlywithin the democracies, as populations age oldepeople make more claims on resources but alsohave more political weight, which means that

Still Many Risks Ahead Lessons Not Yet Learned

We keep making the same

mistakes because we dont

seem to have a lever saying,

Heres something that may

happen in 30 years. We have a

What has posterity ever done

for me attitude.

Jack Goldston


27/42


political solutions to this problem will get tougherin democracies maybe not so much in differentpolitical systems.

Claessens noted that there still dont exist robustenough institutions that can limit bubbles as they

start to get more risky. We dont have well enoughdeveloped regulatory governance, controls onrevolving doors, accountability, and adequatesupervision.

James agreed that the causes still existed. Whilethe housing market isnt as big of a problem, poorpeople are still taking on too much debt. This timeits through other kinds of debt, like credit cards compensating for decreased incomes.

Instead of giving credit rating agencies more bite,James said that they should be eliminated. Gettingrid of ratings agencies would be an important stepforward. Because they are essentially in bed withissuers, this is why they get into the position ofbeing so uniquely important to market outcomes,he noted.

People are trying to wrestle with the question ofwrong incentives in banks and institutions that aretoo large, but it cant be done quickly. It may well

be that the geography of the next financial crisis isslightly different, which wouldnt be surprising. Theydont exactly strike in same place, James added.

As far as global imbalances, we got a slightcontraction of the imbalance in the greatrecession but not a complete unwinding,

James noted. Thats good, because if you keepunwinding it you get a reversal of the global flows thats indeed the kind of thing that pushes aGreat Depression rather than a recession. Theyreincreasing again though, and were also in an erain which cheap money is fueling new

commodity booms and asset booms. So theproblem is were still living in a world thatproduces these crises.

The problems of the financial system on WallStreet have not been resolved, added Roubini.People talk about Dodd-Frank [the Wall StreetReform and Consumer Protection Act in the U.S.,signed into law in 2010], but have we reallychanged the system of compensation? Have wedealt with the corporate governance problem?

Have we divided commercial banking and themore risky shadow banking and investmentbanking? No. So that remains.

The U.S., said Roubini, risks having an anemicrecovery. If and when the public sectordeleverages, raising taxes, reducing transferpayments, cutting spending it will force anotherround of deleveraging of the household sector.Also, the labor market is improving butunemployment is still very high. Most conference

participants agreed that the incipient recoverycould be threatened by a return to business asusual on Wall Street, with little change inexecutive compensation, perhaps a greaterconcentration of risk and a worsening of thetoo-big-to-fail problem, and the lingeringissue of shadow banking practices.

There still dont exist robust enough institutions that can limit

bubbles as they start to get more risky. We dont have well enough

developed regulatory governance, controls on revolving doors,

accountability, and adequate supervision.Stijn Claessens


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Foreign Investors and InternationalFinancial InstitutionsKarl P. Sauvant, executive director of the ValeColumbia Center on Sustainable InternationalInvestment at Columbia University, brought up theissue of risks related to foreign direct investment

(when a company headquartered in one countrymakes an investment giving it some control over acompany in another country).

As firms link up in this manner, Sauvant explained,they create international supply chains. But whathappens when one link in the chainis unable to produce? The supplychain disruption risk is amplified ascompanies move to just-in-timeproduction. Think of the

earthquake/tsunami in Japan or theash cloud emanating from Iceland;but it is unrealistic to askcompanies to have backup for allparts and components in their owncountries, so its a risk we have toacceptunless firms themselveswant to protect themselves againstsupply-chain risk disruption.

I think we can all agree that just-in-time

manufacturing offers lower costs, noted MauroGuilln, Director of the Lauder Institute, but thenit comes at the expense of flexibility. The oppositesystem just-in-case has the opposite benefitsand costs. Most companies have reduced theirworking capital and inventories. To the extentthat companies hold less inventory, recessionsare shallower because companies need to startrestocking right after the first sign of an impendingrecovery. Some of the recent recessions could havebeen deeper if it hadnt been for just-in-time.

Another issue is governance. A multinationalenterprise has affiliates in many countries, butthere is no framework for governance, saidSauvant. There are 3,000 international investmentagreements, most of them bilateral treaties. Is thisfragmented regime enough, or is there a risk of a

governance gap? Sauvant explained that taxationhuman rights and other issues could fall betweenthe regulatory cracks given the scattershot natureof the agreements. One could argue that thecurrent regime is strong because its enforced bythe legal counsels of 80,000-plus multinationals.

But there is a legitimacy risk, he noted.

In addition, Sauvant said, the current system is, bydesign, made to protect foreign investors. It payslittle attention to the interest of host countries antheir legitimate public policy objectives. There is

also a risk of overshooting whenrebalancing the current regime:countries are now including essentiasecurity interest clauses ininternational investment agreement

that are self-judging and whoseapplication can nullify treaty protection

Sauvant also noted that there is a risof FDI protectionism: National FDlaws and regulations are becomingless welcoming, and there is aresurgence of screening mechanismindicating that the cost-benefitanalysis regarding FDI has changed.

If FDI protectionism increases and reduces flows

of such investment, it may also affect trade as onethird of world trade consists of intra-firm trade.

So who ended up paying for the crisis, and is thatmodel sustainable? Christine Wallich, director ofthe Independent Evaluation Group for MIGA(Multilateral Investment Guarantee Agency) ofthe World Bank Group, explained the role of theinternational financial institutions (IFIs) in thecrisis and why they might be unable to help in asubsequent case.

Just like everyone else, said Wallich, the IFIs werealso caught by surprise. A study by the WorldBanks Independent Evaluation Group foundgroupthink and other sociological dynamicswithin the organization that prevented voicesof warning from being heard.

Christine Wallich


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However, once the need became clear, the IFIs didact, lending a substantial amount of money to thestruggling countries, noted Wallich. What helpedwas the World Banks available capital: The globaleconomy had been doing well, so there had beenrelatively low growth in the demand for loans from

the World Bank in the pre-crisis years. As a resultthe Bank had a lot of capital headroom whichwas a blessing in 2008 because the Bank was ableto rapidly increase its lending which almost tripledin one year.

It was a blessing then, but a potential risk for thefuture, said Wallich. By using up so much of itsheadroom for crisis support, the amounts that can

be lent in the future is less. In the next years,absent a capital increase , the World Banks annuallending may be about two-thirds of what it wasbefore the crisis. Interesting, following the lastselective increase in the Banks capital, Chinabecame the number 3 shareholder in the WorldBank, after the U.S. and Japan the first emergingmarket country to become one of the Banksmajor shareholders.

While the World Banks money arguably went to

the right places, the bigger issue is that it was notwell equipped to address countries financial sectorissues, said Wallich. The capacity and expertisethat the bank built over the Asian crisis years wassubstantially eroded. We were simply not equippedto do diagnostics or the analytical work; we wereequipped to lend but not to [insist on] the hard

quid pro quos that our lending is supposed tosupport. The consensus was that we were good atgiving money away but not so good at designing[reform] programs.

Demographic Changes: An Ever Greater Risk

Demographic changes are the source of anotherhuge potential risk to global financial stability,noted Jack Goldstone, professor of public policyat George Mason University. The financial crisismarked a major shift in the global economy

what I call the great divergence in reverse. Thegreat divergence is the leap ahead economicallyof the developed western nations. Reverse it,

and were looking at developing countries likelymaintaining high growth rates for the next decadewhile rich countries will be hard pressed to growmore than 1 to 2 percent per year.

In rich countries, the labor force is aging andshrinking, he noted. Aging populations do not invest.They tend to deplete their resources and pay forcurrent consumption. Shifting the dependencyratio from 30 percent youth to 30 percent seniors isa huge difference: Children 0-14 dont drive cars

or own homes. Any money you put into youngpeople is an investment; you get it back. What youput into entertainment, feeding and clothing ofover 65s are not good investment.

An aging population also can fall prey to reducedinnovation, said Goldstone. One can counter that

The global economy had been doing well, so there had been

relatively low growth in the demand for loans from the World Bank

in the pre-crisis years. As a result the Bank had a lot of capitalheadroom which was a blessing in 2008 because the Bank was able

to rapidly increase its lending which almost tripled in one year.

Christine Wallich


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with investment in basic research and efforts toboost innovation but we are not doing any of that.

Changes will be needed in housing, pensions,transport and medical care costs to accommodatethis demographic shift, he noted. But we dont

seem to be able [politically] to sacrifice for thefuture.

The young people growing up in the developingcountries are the worlds labor force, he added.If they grow up without the education to becomeproductive citizens we all lose. The risk is that wellsee more eruptions as in North Africa. We seehigh youth unemployment and predatory elitesprecisely in the countries that are getting the futureeconomic growth. Its not accidental where

government institutions dont provide security,people invest in family.

Roubini echoed his comments, noting the dangerof having large populations with young, unskilled,unemployed and angry youth. In Saudi Arabia,most young people get only relgious education.Of just the Sunni population, 39 percent of youngpeople age 20 to 24 are unemployed. There is somuch oil there that they can throw money at theproblem, but for how long? Its a time bomb.

Migration will become an issue as this happens,said Goldstone. We have no rational plan to takeadvantage of that, to harness it instead of viewingit as a threat. We have to integrate some developingcountries into the mechanisms of global governancebecause thats where the resources are.

A Vacuum of Global Leadership and GovernanceIan Bremmer, president of the Eurasia Group, aglobal political risk research and consulting firm,

echoed Goldstones comments. When the SovietUnion collapsed, we went from the G7 [group ofseven industrialized nations] to the G7+1. It mayhave been a big deal from a security perspective,but it wasnt really a new world order from aglobalization and economics perspective. Theeconomic paradigm of globalization over last few

years has been multinationals from advancedindustrial economies, mostly democracies, reachin

out to the developing world and bringing theirprofits closer to us, under a set of rules created byand policed by those advanced industrial countrieThat kind of globalization is over. We're going tosee a lot less global leadership; more volatility andpolitical instability; and recrimination especiallysince the rebalancing is away from us.

While it may appear that the world is now movinfrom the G7+1 to the G20, in reality such globalleadership is nonexistent, said Bremmer. We

would like to have global leadership reflecting the20 largest economies in the world. Wed like tohave a new Kyoto protocol, a new Doha round, anew Bretton Woods agreement. But we wont. Thereality is were living in a world that looks muchmore like G-zero: an absence of leadership.

The risk is that well see more

eruptions as in North Africa. We

see high youth unemployment

and predatory elites precisely in

the countries that are getting

the future economic growth.

Jack Goldston

Ian Bremmer and Nouriel Roubini


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This is a problem for both geopolitics andeconomics: Due to globalization everything isinterconnected, added Roubini. There are loadsof externalities, spillovers, and contagion. To

resolve these problems we need global solutionsand cooperation among countries. But not only isthere no political leadership, there is disagreement on monetary and fiscal policy, on exchange rates,on trade liberalization. We live in a world wherethe problems are global but the solutions are stillnational.

If the story over the last few years was the BRICcountries, the new nations to watch are the N11 those said to be the next 11 big growth

economies, including Pakistan, Iran, Egypt, etc.,noted Bremmer. Will there be more inefficiencyin capital flows in such countries? Of course. Willwe be able to predict where those explosions willhappen? Well miss a lot. So the rebalancing is abig deal. It may take some time for countries toacknowledge this shift, Bremmer noted. Were notin the crisis p

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